Should Congress Extend the Payroll Tax Holiday?

Should Congress extend and expand the payroll tax cut it first passed a year ago? In a bizarre but not unexpected role reversal, Democrats insist that at a time of economic uncertainty, Congress must not only extend this tax cut but make it even more generous. And Republicans seem to have somehow discovered a tax break that is deeply flawed. Who is right? They both are.

With the Senate likely to vote on the issue this week, the payroll tax cut has devolved into yet another dreary black-and-white partisan debate. Yet, the consequences of a deeper cut in the payroll tax are ambiguous at best.

Yes, it will put more money into the pockets of people likely to spend it (or at the very least not take money out of their pockets). And while the economic recovery remains fragile, that is probably a good idea. About 160 million workers would benefit and supporters estimate that the expanded tax cut would be worth $1,500 for a typical family. Some Wall Street economists figure this is worth about 1 percentage point of growth. And that’s not insignificant.

But the payroll tax holiday was poorly designed—certainly compared to President Obama’s Making Work Pay Tax Credit that it replaced. Some economists argue that because people are more aware of the payroll tax cut than they were of the obscure MWP, they are more likely to spend the extra dollars. Still, the payroll tax break has big problems.

Because it is so badly targeted, many relatively high-income workers—who are more likely to save rather than spend some of this windfall—would benefit. And if the idea is to boost the economy by increasing demand for goods and services, giving the money to savers isn’t helpful.

At the same time, the Democrats’ proposal would halve the employer share of the Social Security tax for the first $5 million of each firm’s taxable payroll and eliminate the levy entirely for many new hires. Prior attempts to use a payroll tax cut to encourage firms to boost employment suggest that many businesses will take the subsidy for hiring they would have done anyway.

And then there is the not insignificant matter of what this means for Social Security. A major cut in payroll taxes reduces that program’s funding—and as you may have heard, Social Security already faces a significant long-term shortfall. Supporters of the payroll tax break say it is only temporary, so the dollars at stake are relatively small. And besides, they insist, the Social Security Trust fund would be made whole through transfers from the general fund.

But the government is running a $1.4 trillion deficit at the moment, so there are no general funds to fill this hole. In effect, Congress would still have to borrow more money to make up the shortfall—only it would borrow it for the general fund rather than the Social Security trust fund. Economically, it doesn’t matter. But it won’t do much for the credibility of Social Security.

Besides, I worry about just how temporary this tax cut will be. We all know what happens to time-limited tax breaks in Washington. Like vampires, they never die. And this one will be especially tough to kill. Do you know many politicians willing to take the heat for raising taxes on working families by $1,500?

The latest version of the payroll tax holiday would add more than $250 billion to the deficit. And it seems that with that kind of dough at stake, Obama and Congress could have done a better job designing this tax break (actually, they did--with the late MWP credit).

There is a separate argument about how to pay for extending the payroll tax holiday. Democrats want to impose a millionaire’s surtax and Republicans don’t. But leave that argument for another day. On its own merits, extending the payroll tax cut may be better than nothing, but it isn't very good.

Posts and Comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.